What Happens to Banks When House Prices Fall?

ST. LOUIS — An analysis by a Federal Reserve Bank of St. Louis economist suggests that although U.S. banks have invested heavily in residential real estate loans and securities since 2000, they appear less vulnerable to a decline in housing prices than banks in states that experienced large house price declines in the 1980s and 1990s.

The analysis, by St. Louis Fed economist David C. Wheelock, appears in the September/October issue of the Review, the Reserve Bank's bimonthly publication of economic and business issues. The publication is also available online at the St. Louis Fed's web site: http://www.stlouisfed.org.

House prices in the United States have soared in the last five years. The rapid acceleration had led some analysts to forecast a slowdown in the growth of home prices, possibly even a decline in nominal prices. This, in turn, could reduce household wealth, which could restrain the growth of consumer expenditures and overall economic activity.

Wheelock emphasized that the popularity of nontraditional mortgage loans, such as interest-only loans and adjustable-rate loans that permit negative amortization, raises additional concerns about default risk because such loans expose borrowers to more interest-rate and house-price risk than traditional fixed-rate, amortizing loans.

To evaluate the implications of a substantial decline in nominal house prices, Wheelock revisited episodes of large house price declines that occurred in the United States during the 1980s and 1990s. "A historical perspective is necessarily restricted to the fairly recent past because comprehensive data on house prices are not available before the 1970s," said Wheelock. "Nevertheless, the past 30 years contains a rich history of housing booms and busts among U.S. states and cities."

In general, Wheelock found that states that experienced large declines in residential real estate prices in the 1980s and '90s tended to suffer more bank distress, as well as longer and deeper declines in economic activity, than did other states. "In those decades," he said, "banks in states that had steep declines in house prices experienced sharp increases in delinquent loans and declines in net income within a few quarters of when house prices began to fall. Some lenders couldn't withstand those losses and, consequently, failed."

The substantial increase in residential real estate loans and securities held by U.S. commercial banks in recent years is a potentially worrisome development.That concern, however, may be exaggerated, Wheelock said.

"The U.S. banking industry today is considerably better capitalized than it was in the 1980s and early '90s," he said. "Interstate branching, which has been permitted since 1997, makes cross-state comparisons of bank exposure to real estateas well as other measures of bank conditionsless meaningful today than in the '80s and early '90s. Furthermore, as of 2005, banks in general were less exposed to real estate than banks in states that had large real estate price declines in the earlier periods. In addition, interstate branching, which has been permitted since 1977, means that most banks today are probably more diversified than banks typically were prior to the large real estate price declines in the past."

Wheelock concluded: "Most commercial banks appear capable of weathering a modest decline in real estate prices, should one occur."

With branches in Little Rock, Louisville and Memphis, the Federal Reserve Bank of St. Louis serves the Eighth Federal Reserve District, which includes all of Arkansas, eastern Missouri, southern Indiana, southern Illinois, western Kentucky, western Tennessee and northern Mississippi. The St. Louis Fed is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., comprise the Federal Reserve System. As the nation's central bank, the Federal Reserve System formulates U.S. monetary policy, regulates state-chartered member banks and bank holding companies, and provides payment services to financial institutions and the U.S. government.

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